Caveat emptor: by using a 60-year-old inflation model, the Fed will tighten and thus choke the economy, leading to a market crash as of this December.
- The danger of overshoot. We all know by now that the Fed has raised its benchmark rate to 1.0-1.25%. What may be less obvious is the way forward. By the end of
- 2017, it is to have risen to 1.4%
- 2018: to 2.1%, and
- 2019: to 2.9%
This means that based on today's average rate of 1.125%, the Fed plans to raise its target rate by a whopping 158% within two years!
2. 1958 hydraulic macroeconomics. A key reason for this increase is that 94% of the 16 Fed's officials (aka 15 of the 16) still fear inflation. They are basing their anachronistic thinking on the 59-year-old Phillips curve. Its inventor, Kiwi Prof. William Phillips, originally trained as an engineer and as such an adherent of "hydraulic macroeconomics." He postulated an inverse relationship between unemployment and wages: the lower the unemployment rate, the stronger that wages rise, fanning "wage-push" inflation.
3. Time for an overhaul. In our last piece, we already suggested that thinking must move with the times. Strides in technology (aka automation) as well as globalisation are containing wages growth: in yesterday's Financial Times, Henry Hancock wrote on p. 20 that "…real wage growth has collapsed from two per cent in July 2016 to 0.3 per cent this April." Such anaemic growth has resulted in a breakdown in private consumption, whose other depressant has been more and more savings: the lower the interest rate and the greater your job insecurity and the older you get, the more you will save. But you know all that: "wage-push" inflation which is what the Fed fears, died with automation and globalisation! Adieu macro hydraulics!
4. Overshoot risk. So, if these 15 anachronistic Fed officials don't "move their cheese," i.e. change their fundamental approach, watch real Fed Funds choke any anaemic American economic growth. In our framework, the current Economic Time® is characterised by an excess supply of money and - consequently - an excess demand for goods. If the Fed's magnificent 15 continue their Quixotic pursuit of slaying the ghost/ mirage of inflation, they will create an excess demand for money (aka tightening too much) and an excess supply of goods (aka a sharp economic slowdown). Obviously, this worsening in the Economic Time® will hit profits growth, so overvalued markets must tumble.
5. Timing. Having practiced economics for some 40 years, I usually am about six months ahead of the curve. My hunch is that the Fed will raise rates 1-2 more times during its final four meetings of this year (25th-26th July, 19th-20th September, 31st October-1st November, as well as 12th -13th December.) This rate hike will begin choking growth as of 2H18, thereby exacerbating fears swirling around the bundled poison of CLOs containing mortgages, student as well as automobile loans. "Suddenly," the flock of punters will bleat something about "over-valued" markets. Expect the flocks bleating to begin around this December.
6. Investment implication. Stay in liquid stocks with a clear exit plan once the flock of sheep go bearish this December…
Indeed, this is what the BAML survey of 2nd - 8th June concluded: according to 210 money managers,"…global equities are expensive and …monetary stimulus from central banks is excessive." As an aside, I was the father of this Survey when working as the Chief Regional Economist for Smith New Court Far East in London back in 1986, i.e. 31 years ago…
I deliberately am keeping the all-important Treasury out of today's contribution, as this would muddy the already undulating waters… More on this in our next blog.